This invention relates to financial management, and more particularly to capital allocation and risk management.
Banks (or other types of financial institutions) typically maintain capital reserves to offset risks related to credit extended by those banks. The amount of capital maintained by the bank is based on a number of factors related to the credit, such as the risk of default of loans by the bank. Based on measures of a bank's credit portfolio related to the degree of risk of the portfolio, the bank needs to set aside a certain percentage of its credit exposure to protect against bad debt. For example, a bank may know that based on historical experience 10% of its portfolio will likely default on its credit. Failure to adequately offset credit exposure with capital reserves can lead to liquidation of the bank if enough of the credit is subject to default.
The Basel Committee on Banking Supervision has published accords that provide guidelines for retail and non-retail banks. Most recently, the Committee published a consultation paper titled the Basel II Capital Accord (Basel II). Basel II is a compliance regulation that provides for risk sensitive approaches to capital allocation, which is a core part of financial reporting by banks. Basel II also addresses the management of a bank's risk portfolio to ensure that it has a risk sensitive approach to understanding the provisions they need to take to offset bad debt. There are three aspects to the risk. One is market risk; one is credit risk; and one is operational risk. Basel II focuses primarily on operational risk and credit risk. In part, Basel II attempts to improve the measurements of risk within the banking system. In particular, the accord establishes new guidelines for computing the capital requirements maintained by banks to offset credit they have extended. The accord also addresses banks' internal control and management.
Basel II provides for a number of different acceptable approaches to computing quantities such as weighted credit risks, which form the basis of the computed capital requirements. Some of these approaches are complex, making it difficult to implement compliant procedures in accordance with the accord. Furthermore, although Basel II is an extensive document, not all of the requirements and not all the interrelationships of the requirements are explicit. The Basel II requirements are relatively complex and may be difficult for a bank to implement.